George Rauch: Inflation or Die

Here's the good news: Secretary of the Treasury John Snow said in early July, "With interest rates and tax cuts, the economy is beautifully aligned for a takeoff."

For the year the Dow Jones Industrial Average is up 10%, the S&P 500 index is up 11% and the NASDAQ is up 28%. The dollar has come back somewhat. What's more, many newspaper articles are appearing about "the return of the day trader" as well as the return of the retail investor. In general, optimism is spreading.

Don't be fooled.

There are always two trends in the stock market: the primary trend and the secondary trend. The primary trend right now remains down; the stock market is still in bear market posture. The secondary trend is up; the market is up for the year. Should the secondary trend continue to improve, the primary trend could turn around into a new bull market, thereby placing both the primary and the secondary trend in bull market mode. This possibility is remote in an already overpriced market.

Can you make money in this market? No. The average investor cannot make money for several reasons:

1. If the primary trend is down, there are going to be huge gyrations in the stock market averages. This whipsaw usually costs an investor dearly.

2. Values now existing in the stock market are mostly nil. Value comes from price-earnings ratios that are low and yields that are high. Currently, price-earnings ratios and yields on both the DJIA and the S&P 500 Index are equal to past bull market highs, not lows from which a new bull market may be born.

It is important to realize there is a difference between the stock market and the economy. The economy can be improving, pushed along by massive infusions of new money, while the stock market is not improving. The value of a stock's price should be equal to the discounted cash flow that can be expected on that investment over time. That is the classic Dow Theory definition of value in a stock. Cash flow over years at the current value of the stock market is not expected to yield much of a return at all over the next 10 years.

The government agenda

Central bankers are involved in a life struggle against the primary trend of prices, which is deflationary. The Fed's main interest is to create more spending, which provides additional tax revenues. Central bankers do not believe in primary trends. They think they can control the primary trend by setting interest rates and by increasing and contracting the money supply. The whole raison d'etre of a central bank is to control the primary trend.

As such, America is geared up for inflation. We have roughly $38 trillion of individual, corporate and government debt. Interest at 5% means about $2 trillion of our $10 trillion GDP is used to pay interest annually. On Nov. 21, 2002, at the National Economist Club in Washington, D.C., Federal Reserve Board Gov. Ben Bernake said, "Like gold, U.S. dollars have value only to the extent they are strictly limited in supply. But the U.S. government has a technology called the printing press that allows us to produce as many dollars as we wish at essentially no cost. By increasing the number of dollars in circulation, the U.S. government can reduce the value of the dollar in terms of goods and services, which is equivalent to raising the price, in dollars, of those goods and services. We conclude that under the paper money system, a determined government can always generate higher spending and hence positive inflation."

This is the agenda of our government. We must inflate or die. Controlled inflation is essential or our monetary system and current form of government could collapse. There is no in-between. There is no way to compromise this. It is mathematical reality.

Additional food for thought is provided by a new study directed by Kent Smetters, former deputy secretary of economic policy at the U.S. Treasury, and Jagateesh Gokhale, senior economist at the Cleveland Federal Reserve Bank. The study is an examination of the present value of all expected future revenue of the U.S. Treasury, as compared to the present value of all existing future obligations of the treasury. The present value shortfall of funds is $44 trillion, mostly attributable to government pensions, Social Security, Medicaid and Medicare. To put this into perspective, examine the following:

As we said, the only answer: Inflate or die. Obviously the numbers do not work out. There is no way these obligations can be met under our current circumstances of a deflating economy, thereby leaving our government with only viable option: inflation.

Reality check

There are further indicators leading one to believe that the inflate-or-die philosophy is upon us.

China is believed to have 170 million unemployed and migrant workers, equal to 20% of their labor force. Because the Chinese will work for food, shelter and clothing, it will be beyond our lifetime before the cost of labor in China approximates the cost of labor in America. This puts tremendous continuing pressure on our employment and manufacturing base.

For the last several months, corporate insider selling has been four times greater than purchasing of their own stock. In a market that has been going up, why would insiders be net sellers unless the future did not look so bright?

Last week the bond market crashed. Billions of dollars were lost. The bond market dwarfs the stock market. As pointed out above, with $38 trillion in debt, at least $2 trillion annually is needed just to pay interest. With bonds going down, and interest costs therefore going up, the cost of interest is going to increase. An increasing cost of interest causes government expenses to increase. It will lower corporate and individual earnings, thereby further reducing government tax revenue and potentially causing the already exploding U.S. government deficit to become a mega-explosion.

Conclusion

The economy indicates that we are involved in a huge monetary chess match. The four bubbles - the stock market, debt, real estate prices and the dollar - are better positioned for a serious crash than they are for a further increase in value. Indeed, the increasing levels of debt and the increasing manufacturing of money by our government, currently put prudent investors in a position to ask themselves this question: "Am I currently satisfied with my financial position?" If the answer is yes, rather than take the risk of being in a market set up for the volatility that exists, investors are better off conservatively positioned. If the investor is not happy with his current situation, the probability of being really unhappy in the future, if one insists upon playing around with this market, is great, indeed.

Given the current state of the market, investors will be better off in short-term, high-grade bonds, cash or A-rated high-yielding stocks with low-price earnings ratios.

We are in a deflating economy at a time when we desperately need inflation. In this huge monetary chess match our hope should be that the dollar is not checkmated in our efforts to inflate to survive.

Caveat Emptor!

George Rauch is a resident of Longboat Key, owner of Bradenton-based General Propeller Co. and a former Wall Street investment banker.